Markets & Finance

Stocks: Back to the July Lows?

S&P thinks the market is set up for a critical test of the bear market lows

From Standard & Poor's Equity ResearchThe muted rally off the mid-summer lows for the major indexes appears to be complete, and we think this sets the market up for a critical test of the bear market lows.

Overall, we believe the market remains skittish as a lack of conviction by institutions is keeping funds sidelined, and the only movements in stocks seem to be rotational in nature as money flows from group to group. Crude oil bounced sharply higher off some key supports, while treasury bond yields tested their recent lows.

We think the price and internal action in stocks since the July 15 bottom is not good. Overall, volume during the rally was weak, although when we moved into August, it is the lowest-volume month of the year. Advancing volume, which is a good indicator of demand for shares by institutions, was very poor during the rally and is not indicative of buying thrusts that we sometimes see off of bear market or major corrective lows.

The advance-decline line of NYSE advancing volume minus declining volume hit a recent peak on July 23, and has been drifting sideways ever since. The NYSE advance-decline line peaked on August 11 and has since turned lower, and did not confirm the price action of the S&P 500. The advance-decline line of volume on the Nasdaq has acted better than the NYSE during the rally, but in no way reached the peak seen in early June. In addition, since the end of July, we have seen four days where the market declined on an increase in volume, a clear indication that institutions are distributing stock and is possible evidence the rally is in trouble.

Another, longer-term concern for the stock market is the clear and present contraction in liquidity, both in the banking system and its effects on the economy, and in margin debt and its historic effect on stock prices. We are of the belief that monetary policy and the growth, or lack thereof the money supply, is a major contributor to the success of the economy and the stock market. If we were an economist, we would be classified as a monetarist. When money is easy, and credit is flowing, we think this can add appreciably to stock market valuations. Unfortunately, when credit is too easy and the spigots are open, this has many times led to bubbles in asset prices, as in technology stocks, real estate prices and stocks, the Japanese stock market in the late 80's, emerging markets in 2007, and the infamous tulip mania of the 1600's.

For assets, we believe as long as the money supply is growing and credit is easy, prices can go ever higher. However, when the pump is turned off, we think prices are subject to falls. The expansion of margin debt is one of the many fuels that helped the stock market rise going back to at least the 1940's (when our charts run out of data). The trend of margin debt, has many times mirrored the stock market very well, and we think margin debt is a driver of the long-term movements in equities. Therefore, we think it is a good coincident indicator for the overall U.S. market.

The monthly data shows NYSE margin debt peaking in September 2007, just prior to the market top in October. Margin debt, or investor leverage, had been rising since October/November 2002, right at the bottom of the last bear market. Prior to that, margin peaked in April, 2000, right after the Nasdaq peaked. You can never really pinpoint a peak in margin debt, however, it appears that many times, the slope of margin debt will get very steep before the ultimate peak in leverage. The slope steepened towards the end of 2006 as investors rushed into foreign stocks, and more specifically, emerging markets. The slope steepened in 1999 during the "get me in at any price" technology bubble. The slope of margin debt was also very steep in the late 1960’s as well as the early 1970’s, prior to the market peaks in 1968 and 1973.

Since the latest peak in September, 2007, NYSE margin debt has traced out a series of lower highs and lower lows, broke below its 40-week exponential average, and forced a bearish crossover of the 17-week and 43-week exponential averages. While there is no telling when the trend in liquidity will turn up, we won't have much faith or conviction in the stock market either until the trend stops going lower.

Crude oil dribbled down to support early this week and then exploded to the upside on Thursday, catching many by surprise and aiding the S&P Strategy Team's contrarian upgrade of the energy sector last week. Who says you can't catch a falling knife? While luck helps once in awhile, our call back into energy stocks was based on the huge sell off in oil stocks, and our belief that crude oil was "approaching" a bottom from a technical perspective.

The early week decline took oil prices down to two fairly important pieces of technical support, and the more supports in one area, the more likely the market is to at least bounce when it hits these levels. The 200-day exponential average is sitting right at $112, while a bullish trendline, off the lows since August, 2006, is sitting right at $111.

While we thought a bounce was possible, we did not expect to see the fireworks on Thursday, Aug. 21, with crude finishing higher by over $5 per barrel. This is only the sixth time during the almost seven year bull market for crude oil that prices rose $5 per barrel or more in a single day, and they all have come this year. The big daily spikes, so far this year, have all been near a short- to intermediate-term peak in prices.

While we thought that crude could drop all the way to the $100 to $110 range before the correction ends, and think this could still occur, it now appears to us that crude has put in an initial floor. We expect the current rally to run out of gas in the $125 zone, where minor chart resistance lies, the 65-day average sits, and a 38.2% retracement of the decline targets. We then would expect crude to trade in the $110 to $130 area for a couple months, as a base and reversal formation is traced out.